Eurozone spending rules are relaxed

The European Commission bowed to political pressure from Paris and Berlin yesterday, proposing to replace the rigid spending rules of the Stability and Growth Pact with much laxer guidelines.

Romano Prodi, the commission's president, said the reform of the eurozone fiscal regulations was a "credible compromise between economic soundness and political realism".

The proposals allow countries to exceed the budget deficit limit of 3pc of GDP fixed by the Maastricht Treaty if they have moderate levels of public debt or face a prolonged period of slow growth that falls short of deep recession. The vagaries of the economic cycle will be given more weight.

Joaquin Almunia, the economics commissioner, denied that this amounted to a softening of fiscal rigour, arguing that governments would be more willing to accept rules that reflect economic reality.

"This is not about creating a pact a la carte. It is my firm belief that these proposals will provide for a stronger and more credible pact. The principle remains that excessive deficits must be corrected promptly," he said.

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With Germany, France, Italy, Holland, Greece, Portugal all in or near breach of the pact - as well as Britain and six new member states - it had become impossible for the commission to keep up the fiction of maintaining discipline.

It called for sanctions against France and Germany last year for repeated violations, but the big powers clubbed together in the Council of Ministers to let them off the hook. Mr Almunia admitted yesterday that the commission was powerless to hold the member states to account. "At the end the decisions are taken by the council," he said.

The European Central Bank has fought hard to stop any weakening of the stability pact framework, which was first imposed by Germany to prevent heavily indebted states such as Italy reverting to inflationary deficits.

While many economists have called for looser fiscal rules to allow eurozone states to support their economies through the current slowdown, the danger now is a "free-for-all" attitude that will damage monetary union in the long run.

The financial markets, already sniffing trouble, are starting to push up the interest rate spread between the bonds of the eurozone stronger and weaker economies.

The banking firm Morgan Stanley warned earlier this year that this sort of divergence could ultimately pull the euro apart.

It said investors had bought eurozone bonds on the assumption that strict spending rules would prevent profligate relapses in southern Europe, only to discover that this implicit contract had been broken.

Gerrit Zalm, the Dutch finance minister, cautioned against assuming that the EU would turn a blind eye to fiscal laxity that endangered the euro. "The pact will be more flexible for those who have a sustainable pension system and a low debt. But the early warning mechanism will be applied immediately to any member state with public finances that pose a risk," he said.